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Foreign Tax Credit: When Is It Too Late to Change Your Mind?

Many multinational corporations rely on the ability to claim a foreign tax credit for the foreign taxes directly or indirectly paid to other countries. The credit is paramount to sustaining a competitive effective tax rate and avoiding double taxation. For this reason, both internal tax departments and external tax advisers spend much time and energy on the effective use of foreign tax credits. Unfortunately, simply paying a foreign tax does not guarantee a taxpayer a credit against current or future U.S. tax liability. A complex set of rules in the Code can limit or even completely prevent a taxpayer from using its foreign tax credits (see Sec. 904 and the attendant regulations).

Taxpayers whose foreign tax credits have been limited can either deduct the foreign taxes in the year paid or carry any excess taxes forward for 10 years in the hope that the limitation will allow the credit to be used in future years (Sec. 904(c)). After 10 years, the credits will expire, and the taxpayer will not realize any tax benefit. Obviously, a credit, if not limited, is more beneficial than a deduction, but the interaction of the limitation rules and the threat of expiration often can make a deduction the most beneficial option or even the only option for realizing a U.S. tax benefit from the payment of foreign taxes.

Given the uncertainty of future events, taxpayers frequently do not know whether they will be able to use any foreign tax credits that are limited in the year the credits first become usable. Luckily, a taxpayer may wait and see before it is effectively locked in to one choice or the other, or at least that was the prevailing wisdom before a relatively recent Chief Counsel advice (CCA). Generally, a taxpayer is given up to 10 years to change its mind about whether to claim a credit or deduction for foreign taxes paid in a given year, as opposed to the general three-year window on amending tax returns (Secs. 901 and 6511(d)(3); Regs. Sec. 1.901-1(d)). This seemingly generous provision has long been relied on by taxpayers and their advisers, and taxpayers often amend returns within that 10-year time frame to switch between claiming a credit or a deduction as events unfold and circumstances change that make one option more beneficial than the other. However, this practice has come under fire by the IRS in the past few years.

The IRS's Position

In CCA 201204008, released in early 2012, the IRS effectively made the special 10-year window for switching between credit and deduction a one-way street that only allows a change from deduction to credit. According to the IRS, a change from credit to deduction is not eligible for the 10-year limitation period, and that change can be made only within the standard three-year limitation period. Since CCA 201204008 was issued, two additional CCAs released in 2013 and 2015 have reiterated the conclusion from the 2012 CCA and rejected as untimely the claim for a refund based on an election to deduct, rather than credit, foreign taxes paid for a claim made more than three years after the filing of the original return, but less than 10 years (CCAs 201330031 and 201517005).

The IRS's position is predicated almost entirely upon an extremely confined reading of Sec. 6511(d)(3), which is the special provision that extends the general three-year limitation to 10 years in the case of foreign taxes. Sec. 6511(d)(3) reads as follows:

(3) Special Rules relating to foreign tax credit.

(A) Special period of limitation with respect to foreign taxes paid or accrued. If the claim for credit or refund relates to an overpayment attributable to any taxes paid or accrued to any foreign country or to any possession of the United States for which credit is allowed against the tax imposed by subtitle A in accordance with the provisions of section 901 or the provisions of any treaty to which the United States is a party, in lieu of the 3-year period of limitation prescribed in subsection (a), the period shall be 10 years from the date prescribed by law for filing the return for the year in which such taxes were actually paid. [Emphasis added.]

Within the CCAs, the IRS made a point of specifically emphasizing the phrase "for which credit is allowed," indicating that since Sec. 6511(d)(3) specifically uses the term "allowed" as opposed to "allowable," it could only mean that the special 10-year limitation period applies only when the taxpayer amends a return to claim a credit rather than a deduction.

In its misguided attempt at drawing a distinction between two derivations of the same word, CCA 201204008 offered the following definitions, citing what it refers to as "Random House Dictionary, Random House, Inc. 2011."

The distinction between an "allowed" credit and "allowable" credit is an important one. The term "allowable" is defined as "that which may be allowed, legitimate, permissible." The term "allowed" on the other hand, is defined as that which is permitted.

Essentially, the CCA is attempting to assert that the term "allowed" in Sec. 6511(d)(3) implies that a tax benefit, such as the foreign tax credit, already has been received. What CCA 201204008 fails to consider is that the terms "allowed" and "permitted" do not have different definitions than the word "allowable" in the English language. For example, a thesaurus published by Random House lists several synonyms for the word "allowed," including tolerable, acceptable, and allowable.

Precedence Rules

While embarking on an exercise in semantics and relying on a general dictionary to split hairs in an attempt to establish statutory intent, the IRS forgot that the difference, or lack of difference, in the meaning of the two phrases "allowed" and "allowable" in the Internal Revenue Code has been debated and ruled upon several times, most notably in two Supreme Court cases.

Ironically, in both cases it was the taxpayer asserting that there was a discernible difference in the usage of "allowed" and "allowable" in the tax Code, with the IRS maintaining that no relevant distinction existed in either case. In each case, the Court rejected the taxpayer's argument in favor of the IRS's position.

In Virginian Hotel Corp., 319 U.S. 523 (1943), the taxpayer argued that the use of the word " 'allowed,' unlike 'allowable' connotes the receipt of a tax benefit." In part, the Court indicated, "we find no suggestion that 'allowed,' as distinguished from 'allowable,' depreciation is confined to those deductions which result in tax benefits. 'Allowed' connotes a grant" (id. at 526—27).

In Hemme, 476 U.S. 558 (1986), an almost identical argument was presented in which the taxpayer contended that the term "allowed" implied an actual claim or benefit to the taxpayer. Similar to Virginian Hotel Corp., the IRS argued that the term "allowed" had the same meaning as "allowable" and that no distinction should be drawn between the two terms. The Court in Hemme cited Virginian Hotel Corp. in ruling in the IRS's favor. The Court rejected the claim that "allowed" as used in the context of the statute signifies the mandatory receipt or claim of a tax benefit. The Court maintained that:

The term "allowed" is a familiar denizen of the Tax Code . . . In some sections it appears unqualified, while in others, Congress has clearly embellished the term with the "tax benefit" qualification that appellees urge here. . . . Congress failed to so qualify the term "allowed" in § 2010(c), and we will not presume to impart to Congress an unstated intention to do so. [Hemme, 476 U.S. at 566]

The Court's findings in these cases indicate that the terms "allowed" and "allowable" are interchangeable in many contexts. For that reason, it is entirely inappropriate to assign a narrow definition of "allowed" in the Code.

Beyond the debate over terms such as "allowed" and "allowable," CCA 201204008 also has a glaring omission: It fails to address the fact that its interpretation of Sec. 6511(d)(3) is in direct conflict with Sec. 901 and its regulations. After granting taxpayers the choice of claiming a credit for certain eligible foreign taxes paid, Sec. 901(a) further reads, in part:

Such choice for any taxable year may be made or changed at any time before the expiration of the period prescribed for making a claim for refund of the tax imposed by this chapter for such taxable year. The credit shall not be allowed against any tax treated as a tax not imposed by this chapter under section 26(b).

Although the above statutory language is quite clear about a taxpayer's ability to change its election, Regs. Sec. 1.901-1(d) further expounds:

The taxpayer may, for a particular taxable year, claim the benefits of Sec. 901 (or claim a deduction in lieu of a foreign tax credit) at any time before the expiration of the period prescribed by Sec. 6511(d)(3)(A) (or Sec. 6511(c) if the period is extended by agreement).

According to the regulation, a taxpayer can change an election either to a credit or a deduction at any time within the special 10-year time frame prescribed by Sec. 6511(d)(3). The IRS's argument about Sec. 6511(d)(3) effectively would make the language within Sec. 901(a) and Regs. Sec. 1.901-1(d) superfluous because any election to credit would mean that the deduction is not allowed by virtue of the initial election to credit. In other words, CCA 201204008 is advising that Congress and the IRS incorporated meaningless language into Sec. 901(a) and Regs. Sec. 1.901-1(d) by affording the ability to change from a credit to a deduction, which would be precluded by definition if "allowed" carries the meaning asserted in the CCA.

Looking Forward

As evidenced by the recent reliance on this position in CCA 201330031 and CCA 201517005, it appears the IRS is holding firm in denying the 10-year period of limitation to taxpayers amending to change elections to claim credits for foreign taxes to elections to claim deductions. While it should be noted that a CCA is nonbinding authority that cannot be used or cited as precedent, it is the likely response a taxpayer can expect to receive when filing an amended return because it is clearly the IRS's position. If challenged, a taxpayer may appeal and, based upon the analysis provided here, would have the more compelling argument. Unfortunately, the hazards of litigation and the time-consuming nature of the appeals process might very well prevent a taxpayer from pursuing this avenue when weighed against the potential dollar value of the refund in question.

The practical alternative might be for taxpayers to plan around this roadblock when evaluating their foreign tax credit position and use strategies. One way might be to deduct taxes on originally filed returns if the taxpayers are in a loss position for the year or are severely limited in using foreign tax credits. Under this alternative approach, taxpayers can go back and amend returns to claim credits for those previously deducted taxes and carry them forward only when they know they will have an opportunity to use the credits in a future year with excess limitation.

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